Product market competition on the effectiveness of internal control^*

^*Accepted by Phyllis Mo upon recommendation by Jeong-Bon Kim.

Abstract

This paper investigates the impact of product market competition on a firm’s internal control system, which is an important corporate control mechanism. We measure the effectiveness of a firm’s internal control system based on the material weakness disclosure under Section 404 of the Sarbanes-Oxley Act (SOX). Using several measures to capture different dimensions of product market competition, we find that firms operating in competitive markets are more likely to have material weakness under Section 404 of the SOX; further, they are more inclined to disclose multiple internal control weaknesses. These results are robust after controlling for both internal and external governance mechanisms. The results indicate that market competition reduces the effectiveness of internal controls over financial reporting and hampers the quality of a firm’s information environment.

Keywords:

• Product market competition
• internal control effectiveness
• material weakness
• corporate governance

JEL Codes:

• M41
• M42

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Erratum

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

^* Accepted by Phyllis Mo upon recommendation by Jeong-Bon Kim.

1. This is the integrated framework published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

2. According to Auditing Standard No. 2 (AS25) of the Public Company Accounting Oversight Board, a material weakness is defined as “a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.”.

3. Section 404 of the SOX became effective for accelerated filers (public firms with a market capitalization of at least $75 million) for the fiscal years after 15 November 2004 and for non-accelerated filers for the fiscal years after 15 December 2009.

4. COSO Enterprise Risk Management-Integrated Framework Update: http://www.coso.org/ermupdate.html.

5. We find similar results when we include compensation variables in order to control for managerial incentives in examining the link between market competition and internal control effectiveness.

6. Since managerial compensation plays a part in explaining the association between market competition (Karuna 2010) and internal control structure, we control for managerial incentives by including compensation in the regression. We find (in an untabulated analysis) that product market competition is associated with more MW.

7. We test Equation (2) using both ordinary least squares and negative binomial regressions, and we find statistically similar results.